Berndale Securities Ltd v How Trading Pty Ltd

IN THE SUPREME COURT OF VICTORIA

AT MELBOURNE

COMMERCIAL AND EQUITY DIVISION

COMMERCIAL COURT

No. 2023 of 2008

BERNDALE SECURITIES LIMITED (ABN 63 006 687 467)	Plaintiff
and
HOW TRADING PTY LIMITED (ABN 36 101 185 979) and DAVID RICHARD CHARLES WATERHOUSE	Defendants
AND BETWEEN:
HOW TRADING PTY LIMITED (ABN 36 101 185 979)	Plaintiff by Counterclaim
and
BERNDALE SECURITIES LIMITED (ABN 63 006 687 467)	Defendant by Counterclaim

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JUDGE:	JUDD J
WHERE HELD:	Melbourne
DATES OF HEARING:	9-11, 15-18, 22-24, 29, 30 June, 1, 2 July and 5 August 2009; 25 February, 1, 30, 31 March and 7 April 2010.
DATE OF JUDGMENT:	26 May 2010
CASE MAY BE CITED AS:	Berndale Securities Ltd v How Trading Pty Ltd and Anor
MEDIUM NEUTRAL CITATION:	[2010] VSC 216

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CONTRACT – Options trading – Default by client – Default powers – Liquidation of portfolio – Duty owed by broker to client – Duty of good faith – Duty to have regard to the interests of the client – Duty to act honestly and reasonably – Breach of duty when exercising default power – Limitations on liability of client to indemnify broker.

CORPORATIONS – Misleading or deceptive conduct – oral representations by a broker to its client – conduct by silence – Australian Securities and Investment Commission Act 2000 (Commonwealth) s 12DA.

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APPEARANCES:	Counsel	Solicitors
For the Plaintiff	Mr P Anastassiou SC with Mr H Redd	Blake Dawson
For the Defendants	Mr D Grieve QC with Mr A G Melick SC, Mr R Gordon and Ms D Coulton	Nedovic & Co

TABLE OF CONTENTS

INTRODUCTION AND SUMMARY

OPTIONS TRADING

Types of options
Pricing option premiums
Option taker vs option writer – Risk
ACH
Margin
Brokers, market participants and clearing participants
Market makers
Financial modelling – The “Greeks”
Trading

CHAPTER 1

CHRONOLOGY

FUNDING BUY BACKS

BUYING PROTECTION

REPRESENTATION BY SILENCE

CHAPTER 2

INTRODUCTION

LIQUIDATION CHRONOLOGY

BERNDALE’S DUTIES

Contract
Fiduciary Duty

COMPETING STRATEGIES

The Portfolio
Value

BREACH BY BERNDALE

CONSEQUENCE

AGREEMENT TO INDEMNIFY MRS WATERHOUSE

HIS HONOUR:

INTRODUCTION AND SUMMARY

Berndale Securities Ltd (“Berndale”) is a member of the Merrill Lynch group of companies. It commenced this proceeding to recover from the defendants, How Trading Pty Ltd (“How Trading”) and David Charles Waterhouse, the balance of an account recording the indebtedness of How Trading to Berndale under a Derivatives Client Agreement dated 24 May 2006. The indebtedness arose in part as a consequence of options trading undertaken by How Trading, and in part as a consequence of action taken by Berndale when unwinding or liquidating the portfolio following default by How Trading. Mr Waterhouse controlled How Trading and guaranteed its obligations to Berndale.

Berndale was not How Trading’s broker for the purpose of placing orders or giving advice. How Trading bought and sold options through Norris Smith Stockbroking Pty Ltd. In order to trade in options it was necessary for a clearing participant, authorised by Australian Clearing House Pty Ltd (the “ACH”), to assume liability as principal to the ACH on each transaction. Norris Smith was a trading participant under the ASX Market Rules, but not a clearing participant. Berndale was a general participant under the ACH Clearing Rules and a general settlement participant under the ASX Settlement Rules. Berndale provided third party clearing services to Norris Smith and How Trading.

The sole business of How Trading was to trade options in shares listed on the ASX. Mr Waterhouse was an experienced options trader through various entities. At different times in his career he had been a bookmaker and professional punter. He commenced to engage in the business of options trading in about late 1998 or early 1999.

Mr Waterhouse approached options trading as a gamble, trusting his judgment that the stock market would move in a particular direction. He traded options without owning the underlying stocks in which options were bought or sold. He regarded hedging as an unnecessary cost. His trading practices had the potential to yield substantial profits if the market moved as Mr Waterhouse predicted; but also exposed How Trading to the risk of substantial losses should the market move against him.

The market had fallen rapidly during the last quarter of 2007 exposing How Trading to potential losses reflected in margin calls made by the ACH on Berndale and passed on to How Trading. The margin, required by the ACH and Berndale, was calculated by reference to a sophisticated risk analysis undertaken by the ACH. The ACH acted as counterparty to seller and buyer under contracts. Berndale was not required to accept the margin calculation made by ACH but did so for the purpose of making margin calls on How Trading.

Until early November 2007, How Trading continued to meet its obligations under margin calls which were satisfied in cash by a direct debit made to an account at Westpac Bank. The ACH held some cash as security and was beneficiary under a bank guarantee, issued by Westpac, in the amount of $1 million. Berndale was not a beneficiary under that guarantee which was, in any event, due to expire on 31 December 2007.

Berndale had been concerned about the level of its exposure under the How Trading portfolio from as early as about February 2007, although it did not appear to take any step to challenge the trading strategy of Mr Waterhouse, nor to obtain security from him or How Trading until after Westpac had dishonoured a margin call made on 9 November 2007 in the sum of $3,784,733.01. On 21 November 2007, the bank dishonoured another margin call of $2,323,753.70. A further call for $2,456,127.76, made on 22 November 2007, was also dishonoured.

On 26 November 2007, Berndale notified How Trading that its failure to meet the margin calls constituted a default under the agreement and demanded that How Trading comply with its obligations. How Trading did not comply. Negotiations between Mr Waterhouse and representatives of Berndale followed, resulting in the execution of a letter agreement on 5 December 2007 amending the Derivatives Client Agreement. Under the December agreement, Berndale permitted How Trading to retain control of its portfolio on condition that the margin was maintained within specified limits and How Trading agreed to procure Westpac to issue a bank guarantee in favour of the ACH and Berndale to the value of $4 million. Mr Waterhouse agreed to provide his personal guarantee to further secure the indebtedness of How Trading to Berndale.

While How Trading was to retain control of the portfolio, its trading activity was limited to risk reduction trades. Such trades might have included the purchase of opposite positions to those which exposed How Trading and Berndale to the risk of financial loss. Risk reduction trades might also have involved a cost – the purchase price of opposite positions. While the intended consequence of authorised trading was to reduce the margin, there was no guarantee that this would occur. Market volatility could result in an escalation of the risk component in the margin calculation and erode the value of any reduction achieved through a buy back.

There was a sense of great urgency in the negotiations leading up to the December agreement. In the absence of agreement, Berndale proposed to exercise its default powers with the consequence that How Trading would lose control of the portfolio and account. The urgency was compounded by the fact that the Waterhouse family was about to fly to Aspen for a holiday. They were scheduled to depart on the afternoon of 5 December. As for Berndale, it was already exposed to financial loss which would crystallise if it took over and liquidated the account. It held no security from How Trading or the Waterhouse family.

Following the December agreement a dispute arose concerning the source of credit to fund buy backs. The dispute came to a head in late December 2007 when Berndale took steps to prevent How Trading from closing out positions without contributing its own cash to pay the premium. In response, How Trading commenced a proceeding in the Supreme Court of New South Wales to enforce an alleged agreement with Berndale under which How Trading was permitted to use the available margin, limited by the agreed cap, as if an overdraft facility to fund the required premium. The dispute was resolved by terms recorded in a letter agreement, dated 3 January 2008. The January agreement also amended the Derivatives Client Agreement.

The January agreement enabled How Trading to retain control of its account. However, by the close of business on 9 January 2008, the ACH margin exceeded the agreed cap of $6.5 million. Under the January agreement, How Trading had 48 hours within which to reduce the margin below the cap. It failed to do so. On 14 January, the following Monday, Berndale notified How Trading that it proposed to take control of the portfolio and exercise its default powers.

As at the close of business on Friday 11 January, the ACH had calculated the net market value of the portfolio at –$5,724,945.99. The defendants relied on the ACH valuation as the indicative cost at which open positions could and should have been closed by Berndale had it acted immediately. Berndale made no attempt to close out the portfolio as the defendants alleged should have occurred.

When Berndale took control of the portfolio on 14 January 2008, it comprised 18,269 open contracts. Most of the contracts were “sold put options” for which How Trading had derived premium income. The portfolio was large by industry standards for a private trader. One measure of its size was the number of open contracts. Another measure was the notional value of the underlying stock which was more than $545 million.

Berndale claimed the sum of $9,960,858.44 including interest calculated to 5 August 2009, and interest thereafter until judgment. That claim was in addition to $4 million already recovered by Berndale under a bank guarantee issued to it by Westpac at the request of Mrs Waterhouse. Berndale’s calculation of its claim took account of the cost of closing out some positions and of trading profits and losses made in the course of hedging the portfolio, as well as the cost of finally disposing of the portfolio at auction on 5 March 2008.

The defendants initially defended the claim by alleging breaches of the Derivatives Client Agreement, a breach of fiduciary duty and a breach of the duty to mitigate. The alleged breaches related to the way in which Berndale purported to exercise its default powers. As the proceeding advanced, that part of the defendants’ case underwent some change. The defendants ultimately alleged that the persons responsible for exercising Berndale’s default powers were incompetent, with no real appreciation of their function. They alleged that Berndale should have, but did not, liquidate the portfolio on and within a few days of 14 January 2008. It was the defendants’ case that had Berndale done so and closed out certain hedging contracts on 22 January 2008, Berndale would not have been entitled to call upon the bank guarantee. That line of reasoning would have the defendants’ benefit from the conduct they alleged was unreasonably undertaken by Berndale in breach of contract.

A very substantial change was made to the defendants’ case in March 2009. They amended their defence and counterclaim to allege that Berndale had engaged in conduct in contravention of s 12DA of the Australian Securities and Investment Commission Act 2001 (Cth) (“the Act”). The defendants alleged that How Trading was induced by oral representations and silence to agree to the terms of the December agreement under which the bank guarantee for the sum of $4 million and the personal guarantee of Mr Waterhouse were provided.

The conduct complained of by the defendants took place at meetings between representatives of Berndale and Mr Waterhouse on 5 December 2007, shortly prior to the execution of the December agreement and delivery of the guarantees. The Berndale representatives involved in the meetings with Mr Waterhouse were John Norman Laws, managing director of equity financing at Merrill Lynch; Robert John Forbes, a director of Berndale; and Michael Charles Horrax, general counsel for Merrill Lynch.

The alleged representations were to the effect that Berndale would fund premium required by How Trading to undertake risk reduction trades permitted under the December agreement; and that neither Berndale nor Merrill Lynch would trade on their own account for the purpose of reducing their own exposure to the How Trading portfolio. The defendants alleged that the representations were untrue because at the time they were made Berndale had no intention of funding the risk reduction trading; and because Merrill Lynch had already undertaken risk mitigation trading on its own account and intended to continue to do so. The risk mitigation transactions became known as the Merrill Lynch house trades. The conduct by silence relied upon by the defendants was Berndale’s failure to inform them that Merrill Lynch had already undertaken risk mitigation trading.

How Trading also alleged that in reliance upon the contravening conduct of Berndale it agreed to indemnify Mrs Waterhouse for any amount for which she became liable to Westpac under the bank guarantee granted at her request. It counterclaimed for damages or restitution in amounts calculated by reference to the amount paid under the bank guarantee. The evidence supports such an agreement and, insofar as it may be relevant, I find that there was an agreement by How Trading to indemnify Mrs Waterhouse.

The parties divided the case into two parts. Chapter 1 concerned the defendants’ misrepresentation case. Chapter 2 concerned the defendants’ challenge to Berndale’s exercise of the default powers.

The defendants’ Chapter 1 case depended substantially upon the court accepting the evidence of Mr Waterhouse about his conversations with the representatives of Berndale on 5 December 2007 prior to executing the December agreement. The Chapter 2 case involved an analysis of Berndale’s contractual and other duties owed to How Trading when purporting to exercise default powers, whether Berndale breached any of those duties and if so, with what consequence.

Mr Waterhouse prepared and filed a lengthy, detailed and at times self-serving witness statement. He presented as an intelligent and astute businessman and witness. It was apparent that he had spent a great deal of time in preparation for giving his evidence. The account given by Mr Waterhouse of the important events and conversations on which the defendants’ misrepresentation case was based was challenged by Berndale.

The evidence of Berndale’s witnesses, Messrs Laws, Forbes and Horrax, was generally unsatisfactory. It was imprecise, vague and defensive. That said, I am not persuaded that the representations alleged by the defendants were in fact made. Much of the evidence given by Mr Waterhouse in support of the misrepresentations and reliance was implausible. The background circumstances, objectively ascertained, made his evidence improbable.

Berndale went further and submitted that much of the evidence given by Mr Waterhouse about the relevant conversations was a recent invention and contrived. I have found that the defendants’ misrepresentation case was opportunistically constructed around known facts and circumstances to make it appear plausible. The oral evidence of Mr Waterhouse exposed a house of straw. I reject the defendants’ misrepresentation case. I have also found that Berndale’s failure to inform How Trading of the Merrill Lynch house trades was not misleading or deceptive.

The defendants’ Chapter 2 case involved allegations of breach of contract and fiduciary duty. The breach of contract case ultimately advanced by the defendants virtually ignored the pleadings. Berndale claimed that when exercising its default powers it was unfettered by any obligation of good faith to act reasonably (in an objective sense) or to have regard to the interests of its client. Its fall-back position was that it was required to act as a reasonably prudent broker protecting its personal obligations.[1]
[1]Derivatives Client Agreement cl 6.4(l).

The defendants submitted that Berndale owed to How Trading a positive duty to act reasonably when exercising the default power. That duty, they submitted, was an incident of an obligation of good faith arising under the contract. They alleged that Berndale breached the duty through the incompetent handling of the How Trading portfolio. They alleged that instead of taking the simplest and most straightforward course available – to close out all positions immediately – Berndale engaged in risky and expensive trading, changing the nature of the portfolio into a hedged package of positions for auction.

The defendants submitted that, by reason of its breach, Berndale was not entitled to claim the amount stated in the account, which had been inflated by its own improper conduct. Instead, Berndale should be confined to the value of the portfolio at the time it took control, on 14 January 2008 or the value at which the portfolio could have been realised in the market had Berndale closed out all positions immediately. The defendants alleged that had Berndale taken that course they could have done so at a cost which approximated the ACH valuation made as at the close of business on 11 January 2008.

The defendants argued that their account with Berndale should also be credited with the amount of the profits that would have been made by Berndale from the short sale of stock and trading in XJO put options, on the basis that those contracts should have been closed out on 22 January 2008. Alternatively, they claimed a credit for the actual profits made. The defendants claimed the notional or actual profits on the basis that, when exercising its default powers, Berndale was acting as agent for How Trading and breached a corresponding fiduciary duty to minimise its loss. They alleged that a proper accounting would have resulted in a reduction of How Trading’s liability to nil or thereabouts, denying Berndale any right to draw down on the whole or most of the bank guarantee.

The defendants argued that Berndale was liable in damages to How Trading to the extent to which the amount recovered under the bank guarantee exceeded the correctly adjusted indebtedness of How Trading to Berndale. They claimed in the alternative that Berndale was unjustly enriched at the expense of How Trading by recovering under the bank guarantee.

Through its Merrill Lynch witnesses, Jason Kieran Ryan and Paul Lindsay Craft, Berndale advanced its strategy to unwind the portfolio and sought to explain and justify the strategy. Mr Ryan was head of equity risk and derivatives trading in Australia at Merrill Lynch. Mr Craft was a derivatives trader at Merrill Lynch. Their stated purpose was to prepare the portfolio for auction. They said that this necessitated very significant hedging in order to make the portfolio more attractive to potential bidders. Almost two months elapsed from the time Berndale took control of the portfolio until auction.

Messrs Ryan and Craft ridiculed the defendants’ reliance on the ACH valuation as a measure of what could have been achieved in the market had Berndale closed out the positions on and within a few days of 14 January 2008. They said they never relied on the ACH valuation. They justified their auction strategy by asserting that it would have been impossible to close out positions immediately at a reasonable price, although they did not explore the market to ascertain what was possible or at what price. They refused to be drawn on what a reasonable price might have been.

After completion of the evidence and final submissions, but before judgment was delivered, the defendants made application to reopen their case and adduce further evidence. I have acceded to their application. The new evidence concerned the liquidation of the Lift Capital options portfolio about a month after the How Trading portfolio had been sold at auction. It was a portfolio of similar size to the How Trading portfolio. Messrs Ryan and Craft were also involved in that liquidation, which was completed within a few days of Merrill Lynch assuming control of the portfolio. No mention was made by Mr Ryan or Mr Craft at the trial of their involvement with the liquidation of the Lift Capital portfolio. It was not in dispute that the defendants were unaware of the relevant events until early February of this year.

While Berndale valiantly tried to distinguish the portfolios, I regard the evidence given about the Lift Capital portfolio as highly relevant at a number of levels and I have taken into account the relevant and admissible evidence adduced on the defendants application to re-open the trial. I was surprised and disappointed, to use a neutral phrase, that the role of Merrill Lynch in the liquidation of the Lift Capital portfolio was not disclosed by Berndale prior to or during the trial. Berndale could not have overlooked the potential impact of that evidence on the defendants’ case and on its case in response.

On their own evidence Messrs Ryan and Craft did not explore the possibility of closing out all positions in the How Trading portfolio as quickly as possible. They said that to close out all positions in the market at that time would have been imprudent. They said that it would not have been possible to buy back positions at a reasonable price. Mr Ryan said that he decided upon an auction strategy as early as December 2007.

I have found that the rationale advanced by Messrs Ryan and Craft at trial for not immediately closing out all positions to be the product of reconstruction and an opportunistic invention. I have rejected the defendants’ case against Berndale for breach of a fiduciary duty owed to How Trading, although I have found that Berndale owed a duty of good faith to How Trading when exercising the default powers. Berndale was required to have regard to the interests of How Trading and to act honestly and reasonably. Such duties are entirely consistent with the powers contained in cl 6.4 of the Derivatives Client Agreement, including Berndale’s right to protect its own position.

I do not accept the evidence of Messrs Ryan and Craft in which they sought to explain why they could not, and thus did not, close out all positions on and within a few days of 14 January 2008. That evidence was accompanied by an equally implausible, but necessary, assertion that it was always their purpose to prepare the portfolio for auction.

On about 6 February 2008 Berndale commenced to make arrangements to conduct an ASX approved auction. It is not clear precisely when that decision was made, but I am satisfied that it was not made when Mr Ryan said it was. It was not made prior to Berndale taking control of the portfolio and cannot be employed by Berndale as a justification for the “strategy” implemented over the week commencing 14 January.

Contrary to the evidence of Messrs Ryan and Craft, I have found that there was, in the week commencing on 14 January 2008, a market in which the How Trading option positions could have been closed out. It was a reasonably liquid market and would, if tested, have resulted in transactions at prices close to the ACH valuations. A reasonable broker, looking to protect its own interests, would have at least tested the market. Mr Craft summed up the position when he said,

If I could have sold all of the options in the How Trading [portfolio] on the open market for reasonable prices on Day 1 [14 January 2008] or within several days of Day 1, I would have. If there had have been such a market at a fair price, selling the options on the market would have been the right thing to do. There was no incentive for us not to close down the portfolio in the least expensive and in the shortest time possible. However, there was no market for the number of options positions contained in the How Trading portfolio.

If the evidence of Mr Ryan, to the effect that he had decided to auction the How Trading portfolio as early as December 2007, is to be accepted, he made that decision without regard to the market as it existed in the week commencing 14 January 2008. Berndale did not seek ASX approval for an auction until early February 2008. Mr Ryan also said, contradicting other evidence given by him, that the How Trading portfolio had to be auctioned because Merrill Lynch had exhausted what liquidity they could find so that “we had to go down the route of the OTC auction for the How portfolio, there was no other choice. No other choice.” In my opinion the decision to auction the portfolio was probably made in late January or early February 2008. Thus, an early decision to auction does not support or explain the short sales, hedging activity and delay in liquidation.

Whenever the decision to auction the portfolio was made, whether “very early in the equation” as Mr Ryan insisted, or in late January or early February, the fact remains that Berndale converted the How Trading portfolio, which Mr Ryan described as “toxic”, into a fully hedged parcel of positions. In my opinion Berndale was not authorised to turn a pumpkin into a golden carriage at How Trading’s expense. When exercising default powers under cl 6.4 it was entitled to deal with the portfolio to reduce its own exposure and consequently the exposure of How Trading. It was not entitled to create a new and more attractive product to offer to potential institutional bidders, if that was it’s purpose.

In the absence of a credible explanation by Messrs Ryan and Craft for their management of the portfolio from the outset their purpose is elusive. What then was their purpose if not to prepare the portfolio for auction? What other explanation might there be for the short sales, the expensive hedging and delay in liquidation? Does the absence of a credible explanation establish the defendants case?

Contemporaneous correspondence revealed other possible explanations as to why Berndale might have chosen not to immediately close out the whole of the portfolio. In the week commencing 14 January 2008 Mr Waterhouse was attempting to secure additional finance to enable him to resume control of the portfolio and take it to another broker. By the following week it became obvious that his efforts would not succeed. It was only then that Berndale called upon the bank guarantee. That explanation was not, however, explored in evidence or advanced by Berndale.

Another possible explanation involved the defendants allegation that Berndale had made short sales of stock in the week commencing 14 January in an attempt to profit from knowledge of the imminent publication by Merrill Lynch of adverse trading results. A substantial profit, made from short sales, might have had the effect of eliminating the whole of Berndale’s loss. Messrs Ryan and Craft explained the transaction as a hedge. Their explanation of the transaction was not ultimately challenged by the defendants.

A further possible explanation is that Berndale, treating the portfolio as it’s own, wished to create a risk free hedged portfolio awaiting a final decision as to the best way to liquidate in an orderly manner. Such an objective may have been consistent with the letter of instruction from Ms Harkness, although Berndale advanced a different case.

The absence of a satisfactory explanation by a broker for its management of a portfolio in the exercise of its default powers, does not necessarily translate into a finding that it had acted unreasonably or in breach of its duty of good faith. This was not, however, a case involving the mere absence of a satisfactory explanation. Berndale had advanced a contrived and unconvincing explanation for remodelling or reworking the portfolio into a risk free, fully hedged, portfolio. I have the explanation. Berndale was not authorised under the Derivatives Client Agreement to restructure the portfolio at the expense of How Trading. In the absence of a credible explanation for remodelling the portfolio, when the most straightforward, simple and available course was to close out all positions, Berndale’s conduct was inexplicable and unreasonably. It was also unauthorised.

Berndale also breached its duty to act reasonably by failing to have regard to the available market within which to close out the portfolio as soon as possible with the object of limiting its own liability and consequently the liability of the defendants. A reasonably prudent broker in the position of Berndale, acting to protect its own interests, and mindful of the interests of it’s client, would have considered closing down the portfolio as soon as possible and tested the market for liquidity. Had Berndale done so, in the market that existed on and within a few days of 14 January, I have no doubt it would have found the necessary liquidity at prices at or near ACH valuations. In the circumstances a reasonable and prudent broker could and would have liquidated the portfolio by closing out all positions within the week of 14 January 2008.

Berndale’s claim for payment of the account is made under cl 6.4 of the Derivatives Client Agreement. It was not authorised to recover the cost of transforming or remodelling the portfolio. Further, having breached its obligations to How Trading in the exercise of those powers, Berndale was not entitled to debit the How Trading account with the cost incurred when purporting to exercise the default powers. Berndale is not, however, required to bring to account the profits made during that process. Berndale’s dealings with the account on and after 14 January 2008 were entirely at its own risk.

As a consequence, Berndale’s claim against How Trading must be confined to the value of its exposure under the contracts in the portfolio it took over on 14 January 2008. The value may be arrived at in a number of ways. One possibility is the ACH valuation as at the commencement of business on 14 January 2008. The value of the portfolio at that time was ―$5,724,945.99. Another possibility is to assume that Berndale “did the right thing”, as Mr Craft put it, closing out all positions within the week of 14 January 2008. Doing the best I can, but without any assistance from Berndale in having relevantly tested the market at that time, I would attribute the same value to the portfolio as the ACH valuation. I am fortified in that view by the evidence relating to the Lift Capital portfolio. From that amount must, of course, be deducted the sum recovered by Berndale from Westpac under the guarantee.

The counterclaim is dismissed. I will give the parties an opportunity to formulate proposed orders reflecting these reasons and will hear them on the question of costs.

OPTIONS TRADING

Options trading may be well understood by many. What follows is a brief outline of those features of options trading in the relevant market which will assist an understanding of the issues in this case.[2]
[2]A convenient overview of options trading is to be found in the judgment of Lockhart J in the Federal Court decision in Sydney Futures Exchange Ltd v Australian Stock Exchange Ltd (1995) 128 ALR 417, 420.

Options are a form of derivative traded over the ASX ‘deriving’ their value from the underlying security on which they are traded. Options are most commonly traded over stocks but may be tracked over other types of securities such as an index. Options may either be bought (taken) or sold (written).

An option is a contract between two parties giving the taker (buyer) the right, but not the obligation, to buy or sell the underlying security at a pre-determined price (strike price) on or before an expiry date. To acquire this right the taker pays a premium to the writer (seller) of the contract.

Three features of options contracts have been standardised by the ASX; (1) the underlying security; (2) the expiry date and (3) the exercise or strike price. Each options contract is standardised to include 1,000 underlying securities, usually shares.

The expiry date is the last day of trading for a contract series. Options over shares usually expire on the Thursday before the last business Friday of the month. Index options expire on the third Friday of the contract month. Option contracts are usually listed with an expiry date for the next three months of a quarterly expiry cycle. For example, options would be available with expiry dates in January, April and July. In addition to quarterly expiry cycles, a current or “spot” month is also available. These options expire at the end of the current month.

Types of options

There are two forms of options; call options and put options. Call options give the buyer/taker the right, but not the obligation, to buy the underlying shares at a predetermined price on or before a predetermined date. For this right the buyer/taker pays a premium as determined by the market, to the writer/seller of the options. Premiums are quoted on a cents per share basis. As each option contract provides for 1,000 shares, the premium as quoted, is multiplied by 1,000 to convert it to a dollar sum. On the other side of the transaction, a writer/seller of a call option is obliged to sell the underlying shares to the buyer/taker, if they exercise the option at the strike price. The writer is paid and keeps the premium regardless of whether the option is exercised.

Put options give the buyer/taker the right but not the obligation to sell the underlying shares at a predetermined price (strike price) on or before the expiry date. That is, the buyer/taker is only required to sell (deliver the underlying shares) if they choose to exercise the option. Again the taker/buyer pays a premium to the person writing/selling the put option. The writer or person selling the put option is obliged to buy the underlying shares at the strike price as agreed.

Options are commonly referred to as either “American” or “European”. An American option (most options on the ASX) may be exercised at any time prior to the expiry date, whereas a European option may only be exercised on the expiry date.

Pricing option premiums

The price of an option premium is influenced by two components; (1) the price of the underlying share or intrinsic value; and (2) the time left until expiry or time value.

An option may have intrinsic value when the exercise/strike price differs from the price of underlying stock. In the case of a call option (where the taker/buyer has a right to buy), the option will have intrinsic value, when the strike price is below the market price of the share. For example, a July $30 CBA call option has intrinsic value if CBA is trading at above $30. Options with intrinsic value are said to be “in the money”. A trader will buy call options if they think the share price will go up and sell call options if they think the share price will go down.

In the example, if CBA shares were trading at less than $30, the call option would have no intrinsic value, because it only provides the right to buy the shares at a price higher than the market price. Needless to say, if the share price is below the strike price, it is better to buy the shares on the share market and let the option expire worthless. In this case, the option is said to be “out of the money”.

Put options are the opposite of calls. If the strike price is greater than the market price, the taker may exercise the option to sell the shares at that price. Consequently, if, in the July $30 CBA example, CBA is trading at less than $30, the put option will be in the money. A put option will be out of the money if the stock price is higher than the strike price. In such a case, the option would not usually be exercised and would expire worthless.

Time value represents the period of time remaining until expiry of the option. This is affected by several factors including: (a) time till expiry; (b) volatility; (c) interest rates; (d) dividend payments; and (e) market expectations. As a general rule, the following holds true. The longer the time to expiry, the greater the time value of the option. The more volatile the price of the underlying stock, the higher the premium will be. This is due to the wider range over which the stock can potentially move. A rise in interest rates will usually push call option premiums up and put option premiums down. If a dividend is payable on underlying shares during the life of an option it will usually reduce the premium of a call option and increase the premium of a put option higher. Holders of options contracts who do not own the underlying securities are not eligible for dividends payouts. Ultimately, supply and demand will determine the market value of all options. During times of strong demand premiums will be higher.

Option taker vs option writer – Risk

The premium paid by the taker represents an assessment of the maximum loss possible on the option. This is because the taker is under no obligation to exercise their right under the option contract. The taker of a put option and the seller of a call option is not required to own the underlying security. If the writer of a call option does not own the shares, they would be obliged to buy the shares at market price in order to sell at the strike price under the option if expressed. Such options are known as “uncovered” or “naked”. The writer of put options is obliged to buy shares from the option holder at the strike price and is thereafter exposed in a falling market. In such circumstances, in theory, the writer of put options would be obliged to buy shares from the option holder at above market. To avoid that risk, the writer will usually choose to “close out” a position prior to expiry.

An option may be “closed out” by obtaining a corresponding option in the same contract series. For example, if a put option is written/sold, it may be liquidated or closed out by buying/taking an identical put option from another party. Each contract effectively cancels the other out, and the seller/writer under the first contract is discharged from its obligation. A loss may be incurred, if when closing out a written put option, the premium paid is higher than the premium received under the original written/sold options contract. On average, less than 15 per cent of options are exercised. The remaining 85 per cent are closed out or expire unexercised.

ACH

The options market in Australia is operated by the ASX. The ACH administers the clearing facility for the ASX options market. Clearing is the process by which a “clearing participant”, authorised by the ACH, trade and settle option contracts on their own and on behalf of other brokers. Options registered with the ACH are contracts between the clearing participant and ACH on a principal to principal basis. Under the Clearing Rules the ACH becomes central counter-party to both the buying and the selling broker. To ensure the obligations of the options writer, who is exposed to risk in the underlying stock price, the ACH requires the payment of margins as security. ACH calls the margin from a broker or clearing participant, who then calls the margin from the client. This means that the buying and selling brokers only deal with the ACH in the settlement of option contracts and neither broker has to rely on the other to perform under the contract.

Margin

When calculating its margin requirements the ACH uses the Theoretical Intermarket Margining System (“TIMS”). The margin so calculated has two components:

(1)The premium margin is the market value of the position at the close of business each day. It represents the amount that would be required to close out the options positions;

(2)The risk margin covers the potential change in price of the option contracts assuming the maximum probable intra-day movement (daily volatility) in the price of the underlying security. The daily volatility figure, expressed as a percentage, is known as the margin interval.

The TIMS is designed to evaluate the risks associated with an entire options portfolio and calculate the total margin payable, taking into account the volatility of the underlying stock. Volatility refers to the size and frequencies of price fluctuations. In times of increased volatility, the margin is likely to increase. It is important to note that the clearing participant, as principal, is initially liable to pay the margin. The clearing participant may require additional margins from a client to further secure its liability to the ACH. Brokers, clearing participants and the ACH may use different margining standards and the resulting margin may be different. When a clearing participant makes a margin, say from the client, it must generally be paid within 24 hours. If payment is not forthcoming the account is in default and the clearing participant is entitled to take prescribed action in relation to the client account and portfolio.

Brokers, market participants and clearing participants

Brokers provide a range of services to their clients. A “full service broker” offers both trading and clearing services. Norris Smith offered only trading services, contracting with Berndale to provide clearing services. For that purpose Norris Smith entered into an agreement with Berndale. How Trading, a client of Norris Smith, also entered into an agreement with Berndale as clearing participant.

Market makers

Market makers provide liquidity in the market by providing quotes in certain options series. Under the ASX rules, each market maker is assigned one or more securities in which they must meet certain obligations. Market makers may be required to make a market on a continuous basis only, to quote requests only, or both. Continuous operators are obliged to make a market on a continuous basis, providing orders continuously in a designated number of series for specified underlying securities. Each order must be for a minimum quantity and at or within the designated maximum spread requirements.

A market maker assigned to respond to quote requests must provide orders on request for a certain percentage of the time for designated series, for the minimum designated quantity and within the maximum designated spread. The category of the security determines the maximum spread (the difference between the bid and the price) the designated market maker may quote when making a market and the minimum number of contracts for which the market maker must quote a price.

Thus, while market makers are intended to provide liquidity there is no guarantee that at any one time all series will have prices displayed. In the present case there was no suggestion that there was no available market on and from 14 January 2008 to enable Berndale to close out the How Trading positions. The question was price.

Financial modelling – The “Greeks”

Traders often apply mathematical modelling, colloquially known as “the Greeks” to assess the risk within an options portfolio and where that risk lies. The “Greeks”, commonly referred to as Delta, Gamma, Vega and Theta, are derived from the Black Scholes option pricing formula. The professional market uses the Greeks to measure how much hedging is needed to balance a portfolio.

Delta represents the change in value of an option (that is the change in premium) due to a change in price of the underlying securities. It is generally measured in a dollar amount. For example, an option with a delta of 0.5 will move half a cent for every one cent movement in the underlying stock. In a portfolio of 100 options the Delta multiplied by 100 is the number of shares required to create a neutral hedge. That is, to create a portfolio that would be worth roughly the same whether the stock price rose by a small amount or fell by a small amount. A “delta neutral” portfolio is intended to ensure that a change in the value of the options held due to a change in the underlying share price would be almost exactly offset by a corresponding change in the value of the options.

Gamma is the measure of the change in delta for a change in the value of the underlying stock price. Gamma-1 is the rate of change for delta when the market has fallen 1 per cent. The rate of change from gamma-1 to gamma-5 is not linear even though gamma-5 measures the rate of change when the market has fallen 5 per cent. A large gamma measurement will reflect a high level of exposure to change in the underlying stock. It is generally employed as a trigger for hedging or hedging adjustments. Gamma is an indication of the stability of a portfolio. The smaller the gamma the less often a delta hedge needs adjustment to maintain a delta neutral position.

Vega measures the change in option price given a change in volatility of the underlying stock. Theta is the change in option price given a one-day change in time to expiration. It is also referred to as time decay. Volatility is a measure of the precast or expected change in the price of underlying stock over a period of time.

Trading

Trading in options may involve up to four parties. Under the Market Rules a broker must be admitted as a “market participant” to execute trades on the financial market, whether for clients or as principal. Section 3 of the Market Rules provides for the admission of market participants by the ASX. The broker or market participant may permit a client or “authorised person” to place “orders”. Orders are defined as instructions to enter into a derivatives market transaction or cancel a prior instruction.

A market participant may be granted “trading permission” by the ASX in respect of one or more financial products on the “trading platform” under section 12 of the Market Rules. The trading platform is made available by the ASX to trading participants for the entry of trading messages, the matching of orders, the advertisement of invitations to trade and the reporting of transactions. Trading messages are those messages submitted into a trading platform relating to trading functions, such as orders, amendment or cancellation of orders and the reporting or cancellation of market transactions.

All options trades executed on the ASX financial market are cleared through the ACH as central counterparty. To be eligible to clear trades through the ACH, an entity must be admitted as a “clearing participant” under section 3.1 of the Clearing Rules. ACH may admit an applicant as either a direct participant or general participant. A direct participant is authorised to clear a category of market transaction for itself and its clients. A general participant is admitted to clear a category of market transactions for itself, its own clients, other participants and their clients, and market participants and their clients. When trading in derivatives is undertaken the ACH requires participants to deposit ‘margins’ as a form of security to support the obligations under open contracts.

Each trading participant is given trading permission to submit trading messages and matching of orders in a trading platform. Once a client instructs its broker to buy or sell a contract, the trading participant enters the buy or sell order into the trading platform and the trading platform matches the order with a corresponding sell order entered into the trading platform by another trading participant. Under market rules, upon the matching of orders in the trading platform, a contract is formed between the trading participants whose trading messages are matched. The terms of the contract are defined by the relevant series, price and volume. Where the transaction is cleared by a clearing participant, such as Berndale, the rights and obligations of the trading participant (here, Norris Smith) are assumed by the clearing participant as principal.

Upon registration of a contract, ACH will novate the two corresponding contracts which are replaced by two “Derivatives CCP Contracts” with the following effect: (a) obligations owed by the seller to a buyer are replaced by obligations in the same terms owed by the seller to ACH and by obligations owed by ACH to the seller; (b) obligations owed by a buyer to a seller are replaced by obligations in the same terms owed by the buyer to ACH and ACH to the buyer. In this way the ACH acts as the central counterparty to both sides of the contract and the participants have corresponding obligations to ACH.

CHAPTER 1

The proceeding commenced by Berndale was a claim for a debt with an alternative claim for damages. Prior to March 2009, the defendants’ defence and counterclaim did not include a Chapter 1 case in which relief was sought on the basis of misleading or deceptive conduct. Mr Waterhouse said that he did not discover the facts revealing the falsity of the representation concerning “buying protection” until he had reviewed Berndale’s discovery in February 2009. He said that it was only then that he realised the significance and falsity of the related representations. Mr Waterhouse conceded that he was not dependent upon his review of discovered documents to reveal the significance of the representation concerning the funding of buy backs after 4 December 2007.

In the defendants Chapter 1 case, the credit of Mr Waterhouse was crucial. The plaintiff challenged his evidence as unreliable and in material respects deliberately false and contrived. It submitted that the evidence of Mr Waterhouse in relation to his conversations and dealings with representatives of Berndale on 5 December 2007 was a contrivance, invented after he realised that his Chapter 2 case was fatally flawed.

In March 2009 the defendants were given leave to file and serve an amended defence and counterclaim in which they relied for the first time on contraventions of s 12DA of the Act. The conduct relied upon was comprised of two promissory representations alleged to have been made on behalf of the plaintiff and a failure to inform. The promissory representations alleged to have been made were as follows:

(a)Berndale would provide the funds necessary to permit How Trading to buy back put option positions which it had sold so as to reduce its liability to Berndale under the Agreement; and
(b)that Berndale would not enter into any transaction to hedge or otherwise buy protection in relation to How Trading’s account under the Agreement.

In a subsequent amendment, the defendants expanded the scope of the second representation by including a reference to the Merrill Lynch group of companies so that the alleged representation was that “neither Berndale nor any other member of the Merrill Lynch group of companies would…” In addition to the promissory representations, the defendants relied upon Berndale’s failure to disclose the fact that from late November 2007 Merrill Lynch had entered into hedging transactions, on its own account, designed to protect the group from any loss the group might suffer by reason of its exposure to the How Trading portfolio. It is common ground that from about 30 November 2007 Merrill Lynch began trading index put options, futures and stock on its house account for the purpose of protecting the group from its potential loss on the How Trading portfolio. These transactions became known as the Merrill Lynch house trades.

Thus the conduct relied upon by the defendants as misleading and deceptive in contravention of s 12DA of the Act fell into two broad categories. The categories were:

(1) funding buy backs; and
(2) Merrill Lynch house trades.
The conduct in relation to the Merrill Lynch house trades had three components. There was the promissory representation, a representation (unpleaded) of a present fact and a failure to inform.

A proper analysis of the defendants’ case of misleading and deceptive conduct in contravention of s 12DA of the Act necessitates a review of the background to and the course of the evidence. The starting point is the defendants’ allegations as pleaded. The relevant allegations are set out below.

2EOn 4 and 5 December 2007 Berndale by its servants John Norman Laws, Robert Forbes and Michael Horrax orally represented to the second defendant that if How Trading provided security to Berndale for the payment of all money for which How Trading was then or may thereafter have become indebted to Berndale under the Agreement in the form of a Dual Beneficiary Guarantee to be issued by Westpac in the sum of $4 million with currency and effect from 7 December 2007 until 6 December 2008 (“the Dual Beneficiary Guarantee”) and if the second defendant provided the Guarantee referred to in paragraph 10 of the amended statement of claim, Berndale would provide funds to permit How Trading to buy back put options which it had sold so as to reduce its liability to Berndale under the Agreement and, further, that neither Berndale nor any other member of the Merrill Lynch group of companies would enter into any transaction in order to hedge or otherwise buy protection in relation to How Trading’s account under the Agreement.
2FThe representations referred to in paragraph 2E above were reiterated in a letter dated 5 December 2007 written by Berndale and delivered to How Trading on that day.
2GThe representations referred to in paragraph [2E] and [2F] above were made by Berndale in trade or commerce and constituted conduct in relation to financial services within the meaning of section 12DA of the Australian Securities and Investments Commission Act 2001 (“the ASIC Act”).
2HAt the time of making the representations referred to in paragraphs [2E] and [2F] above at Berndale’s direction or on its behalf Merrill Lynch (Australia) Futures Limited (“Merrill Lynch Futures”) had entered into certain transactions to hedge or otherwise buy protection in relation to How Trading’s account under the Agreement by trading in index put options, futures and stock and Merrill Lynch Futures continued to do so on and after 5 December 2007.
2IAt the time of making the representations referred to in paragraphs [2E] and [2F] above Berndale intended not to provide funds to How Trading to permit it to buy back put options which it had sold which intention it carried into effect on and after 20 December 2007 by refusing to finance purchase orders then placed by How Trading with Norris Smith which orders, if executed, would have substantially reduced How Trading’s liability to Berndale under the Agreement.
2JBy reason of the facts stated in paragraphs 2H and 2I above the representations referred to in paragraphs 2E and 2F above were misleading or deceptive or likely to mislead or deceive in contravention of section 12DA of the ASIC Act.
2KThe representations referred to in paragraphs 2E and 2F above were about future matters and in light of the facts stated in paragraphs 2H and 2I above Berndale did not have reasonable grounds for making those representations.
2LBy reason of the facts stated in paragraph 2K above and by section 12BB and the ASIC Act, the representations referred to in paragraphs 2E and 2F above are taken to be misleading.
2LAFurther, at no time prior to the second defendant’s execution of the Guarantee referred to in paragraph 10 of the amended statement of claim and How Trading’s entry into the agreement referred to in paragraph 2P below did Berndale disclose to the defendant or either of them that on and following 4 December 2007 Merrill Lynch Futures had entered into the transactions referred to in paragraph 2H above.
2LBBerndale’s failure to disclose to the defendants the fact that on and following 4 December 2007 Merrill Lynch Futures had entered into the transactions referred to in paragraph 2H above constituted conduct that was misleading or deceptive or likely to mislead or deceive in contravention of section 12DA of the ASIC Act.
2MIn reliance on the representations referred to in paragraphs 2E and 2F above the second defendant executed the Guarantee referred to in paragraph 10 of the amended statement of claim.
2NIf Berndale had not made the representations referred to in paragraphs 2E and 2F above, or if it had disclosed the fact that on and following 4 December 2007 Merrill Lynch Futures had entered into the transactions referred to in paragraph 2H above, the second defendant would not have executed the Guarantee referred to in paragraph 10 of the amended statement of claim.
2OIf the second defendant knew of the facts stated in paragraphs 2H and 2I above before he signed the Guarantee referred to in paragraph 10 of the amended statement of claim, he would not have executed that Guarantee.
2PIn reliance on the representations referred to in paragraphs 2E and 2F above How Trading entered into an agreement with Janette Mary Waterhouse (“Mrs Waterhouse”) on or about 10 December 2007 by which in consideration of her entry into an agreement with Westpac as set out in paragraph 7 of the counterclaim it agreed to pay to her an amount equal to whatever sum or sums for which she may become liable to Westpac under her agreement with it.
2QIf Berndale had not made the representations referred to in paragraphs 2E and 2F above or if it had disclosed the fact that on and following 4 December 2007 Merrill Lynch Futures had entered into the transactions referred to in paragraph 2H above How Trading would not have entered into the agreement with Mrs Waterhouse referred to in paragraph 2P above.
2RIf How Trading knew of the facts stated in paragraphs 2H and 2I above before it entered into the agreement referred to in paragraph 2P it would not have entered into that agreement.[3]

[3]Emphasis added.

When requested to give particulars of the conversations alleged in paragraph 2E the defendants provided the following:

The conversations took place during the course of a meeting in Berndale’s Sydney office on 5 December 2007 between Mr David Waterhouse (representing How Trading), Mr John Laws, Mr Robert Forbes and Mr Michael Horrax (representing Berndale). The substance of what was said by Mr Laws with the concurrence of Mr Forbes and Mr Horrax was that if How Trading provided Mr Waterhouse’s personal guarantee and the Dual Beneficiary Guarantee for $4 million Berndale would fund How Trading’s buybacks and would not buy protection in relation to How Trading’s account if it kept the account within the margins set out in the letter of 5 December 2007.[4]

[4]Emphasis added.

At one point during a pre-trial hearing Berndale proposed that the course of evidence should permit its witnesses to give evidence in response to the evidence of Mr Waterhouse concerning the alleged representations. It was conceded by Berndale that, because of the challenge made to the exercise by it of the default powers, it would at least be necessary for its Chapter 2 witnesses to give their evidence as part of its case in support of its claim. The defendants took the contrary position, pressing for a direction that would require the whole of Berndale’s evidence to be adduced before the defendants’ witnesses gave their evidence.

Notwithstanding the highly contentious nature of the Chapter 1 case, I required Berndale to call all of its evidence first and to close its case before the defendants were required to call their witnesses. One consequence of that direction was that the defendants would be required to cross-examine Berndale’s witnesses who participated in the relevant meetings on 5 December 2007, at which the alleged oral representations were made, before Mr Waterhouse gave his evidence.

In preparation for trial a direction was made to the effect that the evidence-in-chief of each witness was to be given by witness statement, although the evidence of and concerning the representations would be given orally. A separate outline of the evidence of each witness in relation to the contentious conversations was to be prepared and exchanged. Notwithstanding those directions, Mr Waterhouse filed a witness statement in which he set out in conversational style a detailed version of the representations allegedly made by Messrs Laws, Horrax and Forbes at the office of Merrill Lynch and Berndale on 5 December 2007. His evidence about those discussions was contained in paragraphs 101 to 111 inclusive of his witness statement.

Mr Waterhouse made his statement available to the media prior to trial. In it he recited in great detail many conversations with representatives of Berndale and Norris Smith, with Mr Tighe (his wife’s financial advisor), and with his wife. He also recited a course of discussions with Mr Ritchie, a Merrill Lynch executive, in which he alleged he was told by Mr Ritchie of his intention to short sell shares in knowledge of an imminent adverse report to be published by Merrill Lynch in the United States. The witness statement was comprised of 257 paragraphs, over 50 pages. Many of the conversations recited in the statement contained assertions of what had been said in another conversation. Much of the proposed evidence appeared to be self-serving.

By filing a witness statement in which the contentious conversations were recorded in such detail, Mr Waterhouse provided Berndale, the court and the media with a very precise recitation of his version of conversations against which his oral testimony might be compared if the relevant passages were to become part of the evidence. As might be expected, Berndale filed and served a list of objections to the witness statement of Mr Waterhouse. It objected to the whole or part of 165 of the 257 paragraphs. Rulings were made in respect of some objections, although it was apparent that much of that to which objection was made might be canvassed in cross-examination. In order to resolve some objections it would be necessary to make findings of fact which may be uninformed and premature if made for the purpose of the ruling. It was apparent that credit would be an important issue and so it was very likely that many of the passages to which objection was made would probably be employed in cross-examination. The defendants submitted that final determination of the objections should be deferred until the end of the evidence. Against that background, I declined to rule on many of the objections, insofar as they were pressed requiring Berndale to revisit the objections in its closing submissions. By then it would be possible to discern what, if any, objections were pressed and how the defendants might justify the inclusion of material which at the outset appeared to be self-serving, irrelevant or otherwise inadmissible.

The oral testimony concerning the conversations overtook the precise formulation by Mr Waterhouse of the conversations found in his witness statement. Also, as might be expected, Berndale cross-examined Mr Waterhouse so as to rely upon much of what was previously objected to in order to establish inconsistency and bolster its case of contrivance. This experience provides an example of where there may sometimes be a lack of utility in addressing objections at an early point in a trial when it is apparent that the course of cross-examination is very likely to traverse relevant passages.

The precise narrative prepared by Mr Waterhouse remained part of his witness statement when adopted by him as his evidence-in-chief. They were not deleted, although Mr Waterhouse was required to give oral evidence of the conversations. He was cross-examined on the content of some of the relevant paragraphs in his witness statement and the defendants’ counsel put to Berndale’s witnesses the precise content of much of them. Set out below are paragraphs 101 to 111, inclusive, of the witness statement dealing with the critical meetings:

101.I attended the office of Merrill Lynch at around 9am on Wednesday 5 December 2007 to sign agreements, the meeting lasted 20-30 minutes. At the meeting, John Laws, Robert Forbes and Michael Horrax, being persons who I understand were all employees of Berndale or Merrill Lynch at the time, were present throughout. This was the first time I had met any of those people in person. I had only spoken by telephone to Laws on a few occasions and only to Forbes once and Horrax never. At the outset of the meeting Horrax tabled a draft letter setting out certain conditions upon which Berndale proposed that the Agreement be varied. One of the terms of Berndale’s letter was that my wife should provide it with a release in respect of any claims that she may have against it. An understanding was reached to the effect that she would do so in a separate document.
102.At that meeting there was extensive discussion about the terms upon which security in the form of the $4 million bank guarantee was to be provided. I said “I’m disappointed Dan Ritchie could not make it and confirm in person, however my wife’s adviser Tony Tighe, who also cannot make it this morning, as he is also travelling overseas in a few hours as well, wants to make it clear that the guarantee will only be provided on the understanding that Merrill Lynch will have no input in any trading of the account nor will they buy any protection against any positions of the account. In other words they are to treat the account as it was before, as if it is not in default. You have not been trading or buying protection against the positions since the account has been in default?” Laws replied “No”, Horrax and Forbes shook their heads with a confused or bewildered look as if to say no. I then said “This agreement confirms that you cannot do anything that is to How's detriment on these positions or take opposite trades in relation to anything on the How Account. Janette and Berndale are now both sharing the risks, Janette more than Berndale, as she is putting up $4 million and Berndale are carrying How for around $1 million less than the $250,000 which we have in cash in the How account. That may increase up to two and half million dollars if the margins increase over the next three weeks. Tony Tighe has made it very clear, as per his letter which I sent to you on Monday”.
103.Laws said, “The margin is $6 million made up of $4.5 million in short-term market value and one and a half million dollars in ACH risk premium. David, we understand what you and your wife's adviser mean. Time is against us. It's all covered in this letter”. I said “Tony Tighe just wanted me to make it very clear to everyone in the room, when I sign the agreement”.
104.The final topic of discussion at that meeting concerned the possibility that market conditions could operate to force the How account above the margin limits which had been the subject of discussion in the emails which had passed between me and Laws. This was the subject of specific reference in point 1 and 2 of an email sent by him to me at 4:15 p.m. on 3 December 2007, a copy of which is at page 034-035 of the exhibit.
105.Laws said: "Now that we have reached an understanding as to how we are to proceed, we will expect you to comply very strictly with the terms of that understanding." I said: "Have no fear, John. As soon as the account goes over these limits, I will be aggressively buying back, as I will have 48 hours within which to bring the account under the limits." Laws said: "That's great. As long as you understand that. David we would like you to reduce the risk margins by buying back positions during the course of the next few months." I said: "John I worked out we only have about $250,000 left in the account, which I will spend on buybacks." Laws said: "Yes, now that we've done this agreement, you are no longer in default and when you have used up the $250,000 we will keep on funding the buybacks, as we have before, at 10% rate, which has been reduced from 15% because you are no longer in default."
106.The meeting concluded within 20 to 30 minutes on the basis that the draft letter, which Mr Horrax had tabled, would be modified to accommodate the various understandings that had been reached. I was to return later that morning with the signed letters and agreements. I also took the forms of release, which had been prepared for execution by my wife and myself, both personally and on the behalf of How.
107.I arrived home and my wife said “David, what happened with Berndale?” I replied “Janette, they acknowledge everything Tony requested” Janette replied “Ok, if Tony says its ok, on the understanding you have to explain to Tony how you will buy back the positions without the guarantee being called up. I must say I am very against it. Why am I doing this, there is no advantage or upside to me and very little to you, this will seriously strain my financial position if they call on the guarantee, just to keep your good reputation”.
108.I then returned to Merrill Lynch's office later that morning and then had a quick meeting with Mr Laws, Mr Forbes and Mr Horrax when I had the releases, which had been signed by my wife, myself personally and on behalf of How… I said, “The agreements are signed on the understanding of this morning's conversation” Laws said, “As promised, we will treat the account pre last month, before you got into trouble. David, How Trading is no longer in default. Time is working against us David; it’s a trust thing. We have carried you for over the last three weeks. If we wanted to do anything against your interests, we would have taken over the account on day one. Our word should be good enough, our reputation is one of the highest in the world of world-class banks, and our interests are aligned. The last thing we would want is to take a set against your positions, which could cause us to take control of the account. We want you to work through this yourself. However we expect you to maintain control of the positions. What happened in the last few weeks was very embarrassing for us with the ASX on the whole. We just want you to get through this. ”
109.I would not have signed the 5^th of December agreement, nor given my guarantee or requested or induced my wife to give a $4m guarantee if Laws, Forbes and Horrax had not assured me that I could buy back positions with funding from Merrill Lynch, and that they would not buy protection on positions on the How Trading option account. Furthermore, I relied on their reputation of honesty when Laws said with Horrax and Forbes both nodding and agreeing that they had not engaged in buy protection on the position prior to that meeting. If I had known they were in fact buying protection (as they were) I would have not signed the letter. I wanted to maintain my good name, but I expected them to honour their promises and not trade against these positions before or after signing that agreement. Had I known that they had already acted and intended to act in the way that they in fact did, I would never have entered into the agreement of the 5^th of December with them.
110.I said to Laws, “Tony Tighe wants you rooting for How. He wants you to still be sharing the risk. It's great that you have confirmed that. The bank said they would have the guarantee ready for you in the next 2 days. I will certainly be pushing my hardest to get it done ASAP” Laws said “David, now you have signed this agreement, please just push hard to get the guarantee from Westpac”. I said “John, as you know I could have walked away and left you with the shell of How, however I value my reputation, that is why I want to do the proper thing here”.
111.Then Horrax asked me for the signed guarantee and Janette’s signed release. I then said to Horrax as I handed them to him “I have them here”. Laws said, “David, from the list of your assets, this guarantee is not worth the paper it is written on. However it gives us credibility in New York." I then left.[5]

[5]Emphasis added.

In his oral evidence-in-chief Mr Waterhouse said that he attended a meeting at the offices of Merrill Lynch in Sydney at around 9 am on Wednesday 5 December 2007. After identifying himself to a security guard he was given access to a floor of the building on which the offices of Merrill Lynch were located. He met Mr Laws in the lift area and was taken to a meeting room where he was introduced to Mr Horrax and Mr Forbes. The four men sat around a large table. Mr Waterhouse said he had not met any of Mr Laws, Mr Forbes or Mr Horrax before that meeting, although he had spoken with Mr Forbes once and with Mr Laws three or four times. He said that each attendee had a copy of the draft agreement that had been circulated the previous night.

According to Mr Waterhouse he made a complaint about the paragraph numbered 8 on page 2 of the document. That paragraph related to a dispute over brokerage and commissions paid by How Trading on its option account for the period 1 September 2006 to 5 December 2007. The issue had been previously raised by Mr Waterhouse in his communications with Berndale leading to the preparation of the draft agreement. Mr Waterhouse gave evidence of his complaint in the following terms:

John, I am not very happy with number 8. I have been trying to get the commissions or, sorry, the interest off Norris and for the last year, and I don't see how just an email from Norris would result in the commissions going back to How.[6]

[6]T 1155: line 7-12.

The complaint by Mr Waterhouse concerning brokerage and commissions was apparently resolved. His evidence continued:
John Laws said words to the effect - something like "It's not a deal breaker. We will put this in a separate document. This is the interest from OCH, we will put this in a separate document and Forbes will work out the actual interest moneys owed." And re the commission that my wife had requested, he said "We will do a separate document for that as well. And we will ensure that you get those funds credited back to How Trading."
Q.Very well. Now, was anything else said on that particular topic of interest and commissions that you can recall?---
A.He said "You have been in default to us for the last two weeks or so, and we will be charging you 15 per cent on the default. However, once we do this agreement," or he could have said "bank guarantee comes into our possession" - I don't know which word he used - "the interest rate will drop from 15 down to 10."
Q. Very well. That covered that topic as far as you can recall, did it?---
A. That's right, yes.

Mr Waterhouse was asked what else he could recall as having been said during the course of that meeting about the draft agreement. He responded:
Horrax said "I'll get your - the new agreement changed and emailed up."
Q.     Yes?---
A.And I believe Horrax went to a phone in the room and spoke to someone and discussed some of the changes.
Q.     Did you have a laptop computer with you?---
A.     Yes, I did.
Q.And was something emailed to you on that computer during the course of the meeting?---
A.Near the end of the meeting, yes. It wasn't emailed automatically, of course, it was emailed 10 or 15 minutes later after that.
Q.Very well. Leaving that to one side, what else was said at the meeting about the terms of the letter that you have before you being - or the draft, rather - being MCH1.13 to Mr Horrax's statement?---
A.     Were you referring to changes to this agreement?
Q.No, I am not talking about any specific changes, I am just talking about the agreement generally, what was proposed, was anything said to your recollection about the content of the letter?---
A.Yes, I said to Mr Laws "I am very disappointed that Dan Ritchie can't make it here today. However, Tony Tighe, Janette's financial adviser, who has been advising her on this situation, also can't make it here this day as he is travelling overseas in a couple of hours' time, but he wants me to make it very clear that the guarantee is only given on the proviso that you don't buy back positions or trade against those positions on the account.
Q.     Yes. Was anything else said by you at this point?---
A.I then said to Laws, "Have you been trading against the positions on the account?" And he looked at me and said "No". And I also looked at Horrax, and I looked at Forbes, and they looked at me with not - not understand them, like they weren't understanding what I was saying and shook their heads as though to say we don't know what you are talking about.
Q.     Did you say anything else at that stage?---
A.I said "Tony Tighe wants to make it very clear that he wants Merrill Lynch to carry on the account as it was before and do nothing to its detriment, not buy opposite positions to the actual How positions on the statement, on the actual account statement, and basically wants to make sure that Merrill Lynch still continue to share the risks, now Janette has come aboard, with her. She is putting up 4 million and you have got approximately $1 million at risk, and wants the risk to be shared."
Q.Very well. What, if anything, did Mr Laws or any other Berndale representatives say in response to that?---
A.He said "We understand. There's a risk margin of 4.5 million - there's a margin of 4.5 with a risk margin of 1.5 making it 6 million today. He said there was a margin of 6 million which comprises of a margin of 4.5 of ACH margin and a risk margin of 1.5. And if the margin increases, then obviously Berndale's risk also increases, and may increase up to $2 million or thereabouts.
Q.     Yes?---
A.     Actually it would have been 3, words to that effect anyway.
Q.Very well. Now, was anything else said about the proposed agreement and how it was to be carried into effect at that point?---
A.He said "We want you to chase up the bank," and I think I rang the bank at that stage to see what the likelihood of getting the agreement ready by Friday. He said that "We expect you to control the account in better terms than you have in the past, and hence we expect you to - if the margins increase we expect you to buy back positions during the - that time." He said - - -
Q.     I'm sorry?---
A.He said "If the margin goes above 7.5 you have got a 48 hour window to buy back and bring the margin back under the agreed limits, and we will fund those at 10 per cent once this agreement is signed," or he may have said "once this agreement bank guarantee is passed over."
Q.I see. Was anything else said by you or by anyone else who was present during the remainder of the meeting, as you presently recall?---
A.Michael Horrax then said "We have a separate agreement for Janette as per your instructions that you don’t want her - or her lawyer does not want her to be in the agreement, and here is also your guarantee to your release, can you bring them back after they are signed."
Q.     Yes. Now, did you then leave the premises at that point?---
A.     Yes.
Q.     And where did you go?---
A.     I returned back to Elizabeth Bay.[7]
[7]Emphasis added.

In relation to the second meeting between Mr Waterhouse and representatives of Berndale took place later the same morning, Mr Waterhouse said in oral evidence that he met with Mr Laws, Mr Forbes and Mr Horrax in the same board room:

Q.And after you had been back to your home at Elizabeth Bay, did you then return again during the course of the 5 December 2007 to the offices of Merrill Lynch in Sydney?---

A.     Yes, I did.
Q.     About what time did you return there?---
A.     It was approximately 1 to 2 hours after the first meeting.
Q.I see. And were you in contact with anyone there when you returned?---

A. Again I was met by John Laws at the reception area.
Q. All right. And did you meet with him and anyone else?---
A.Yes, again Rob Forbes and Michael Horrax, we went back to the same boardroom.

Q. Right. Did you have a conversation with those three men?---
A. Yes, I did.
Q.What did you say to them and what did they say to you as best you recall it?---
A.I think there could have been some discussion, Horrax could have shown me the changes also as per the email. I am not 100 per cent sure as I'm sitting here now. And I said "This guarantee from my wife and my" – sorry, "My guarantee and my wife's future proposed guarantee is given on the conditions as per this morning."

From its analysis of trading during the period 9 to 15 November 2007, Berndale gave examples for special attention. While the six examples appeared to demonstrate a significant gap, in percentage terms, between the ACH valuation and the actual cost to buy back positions, on closer examination the extent of the discrepancy lost much of its force. For example, the ACH valuation, struck at the end of a trading day, may be an entirely accurate reflection at that time notwithstanding fluctuations occurring during the day. The defendants pointed to particular circumstances creating unusual short term volatility. Over those trading days in November 2007, How Trading bought back a large number of open positions at a time of high volatility created by an announcement by BHP of its proposal to take over Rio Tinto. On 12 November 2007, How Trading bought back over 1,200 BHP contracts which matured in June 2008. These were relatively long dated positions that were purchased at between 15 per cent and 25 per cent over ACH valuation.

The arguments advanced by the defendants to dilute the impact of Berndale’s examples had a tendency to undermine a necessarily close correlation between ACH valuations and actual trades on any particular day. At a time of high volatility, a close correlation is less evident due to fluctuations in trading during a particular day or from one day to the next. The analysis of “problematic positions” undertaken by Mr Best, when giving evidence in support of the application to reopen, is exposed to the same criticisms made by the defendants of Berndale’s examples drawn from the November 2007 trades. But in the environment that existed in the week commencing 14 January 2008, it does not seem that wild fluctuations occurred so that the ACH valuation on one day could be taken as a fair indicator of the likely market price on the next. Mr Best’s analysis of the actual trading during the week supports that conclusion. So does Mr Gibson’s valuations of the portfolio over that week.

Mr Gibson’s valuation of the option positions in the How Trading portfolio during the week commencing 14 January reflected a relatively stable market after allowance was made for higher than usual levels of volatility. His valuation improved by about 5 per cent on 15 January compared with the previous day, then deteriorated on 16 and 17 January by almost 20 per cent, after taking into account of the improvement on Tuesday. On Friday 18 January, the variation from Monday was a little over 3 per cent.

The defendants submitted that the ACH valuations of the portfolio over the week also reflected fairly even trading conditions. Valuations were available for 14, 15, 16, and 17 January 2008. They were included in account statements prepared by Berndale and sent to How Trading. The mid-point calculated by Mr Gibson (using his bespoke method) is closely tracked by the ACH valuations, although the ACH valuation for each day is considerably lower. The ACH valuations were as follows: 14 January $5,612,415; 15 January $4,537,292; 16 January $5,461,058; 17 January $5,445,159. A true comparison is not possible, however, because during the early part of the week Merrill Lynch closed out some of the How Trading positions. The evidence did not permit any examination of the impact that had on the validity of the comparison. Nevertheless, the ACH valuations do not support escalating levels of volatility and seem generally consistent with the movement in the valuations made by Mr Gibson.

I am satisfied that had Berndale decided to close down or liquidate the How Trading portfolio on or within a few days of 14 January 2008 it could have done so. That much is not in dispute. The cost of doing so may have exceeded the ACH valuation of 11 January, although the evidence does not permit any assessment as to how much. Mr Gibson thought that on a stable day the discount would be 25-35 per cent. Mr Gibson’s evidence was based on a few conversations and a “best guess”. The evidence of Mr Gibson and Mr Semple was very unsatisfactory when it need not have been. At a time of high volatility, in November 2007, Mr Waterhouse closed out long dated options in BHP shares at between 15 per cent and 25 per cent over ACH valuations. That experience does not, however, translate into a uniform multiplier to be applied across the whole of any portfolio.

Had Berndale decided to test the market for options to purchase to close out the How Trading positions, it would have been in a position to demonstrate with precision the correctness or otherwise of its contention that it was impossible to close out the positions at a “fair price”. The best evidence available was the analysis undertaken by Mr Best who concluded, with good reason, that even the difficult positions could have been closed out in the market at or near the ACH valuation.

If the actions of Mr Ryan, and ultimately Berndale, are to be assessed against an objective standard they cannot be isolated from the source and limitations of the power Berndale purported to exercise. Berndale purported to exercise its default powers contained in cl 6.4 of the Derivatives Client Agreement to eliminate its exposure under the portfolio. I have found that Berndale owed How Trading a duty of good faith when exercising default powers under the Derivatives Client Agreement. In context, that duty required Berndale to act honestly and reasonably. The issue is whether Berndale acted reasonably.

Berndale claimed the right to choose a liquidation strategy, unencumbered by any such duty. Clause 6.4 expressly authorized the closing out of contracts. In my view, Berndale was at liberty to choose an auction provided that such a course was the action of a “reasonably prudent broker…”. The implementation and management of the chosen course of action would also be subject to the obligation of good faith.

Mr Ryan claimed that the decision to auction had been made in advance of Berndale assuming control of the portfolio. Berndale relied upon the early decision to auction to support and explain it’s hedging strategy on and from 14 January. The early decision to auction was inextricably linked to Berndale’s justification for not closing out positions immediately. The strategy, defined by the purpose (auction) and justification (impossible to close out at a reasonable price), became the lynch-pin of Berndale’s response to the defendants’ case.

I find the evidence of Messrs Ryan and Craft in which they sought to explain and justify their unwind strategy to have been exaggerated and contrived. It was a belated attempt to justify their remodeling of the portfolio, the short selling, hedging and delay. The evidence of Messrs Ryan and Craft, to the effect that it was impossible to close out How Trading option positions at a reasonable price, exaggerated the difficulty of finding liquidity. They did not test the market that existed for those positions. Their opinion, to the effect that it would have been impossible, was contradicted by empirical data.

I do not accept that Mr Ryan made the decision to auction the portfolio prior to Berndale having assumed control of the account. It was crucial to Berndale’s case that it maintain, through Messrs Ryan and Craft, that it was always their plan to auction the portfolio. Mr Ryan faltered, however, in advancing his persistent theme when he said that the portfolio had to be auctioned “because we had essentially exhausted what liquidity we could find”. If that is true, the decision was made considerably later than Mr Ryan would have it.

The first mention of an auction in correspondence was around 6 February 2008. An auction of the portfolio was inconsistent with the initial instructions from Ms Harkness. The assertion of an early decision to auction is also inconsistent with the letter from Mr Horrax dated 25 January 2008 to Mr Waterhouse. If Berndale had decided, prior to taking control of the portfolio, to auction the portfolio it did not explain the delay in seeking permission from the ASX. Furthermore, any such decision would have been made without regard to the market at the time of taking control. In my view the decision to auction was made at some time after Berndale called in the bank guarantee and the time communication with the ASX to approve an auction was initiated.

In the absence of the early decision to auction, which underpinned Berndales case, the credibility of the evidence given by Messrs Ryan and Craft about their “unwind” strategy is significantly eroded. The credibility of their unwind strategy is further eroded by the evidence contradicting their assertions that it would have been impossible to close out positions at reasonable prices. Their conduct in relation to the Lift Capital portfolio – the speed with which they closed out the positions and their failure to mention the transaction in the context of their evidence – places the final rock on the credibility of the “strategy” as explained by them.

There is no doubt that Berndale auctioned the portfolio. Whatever it’s initial purpose may have been, by the time the portfolio was auctioned it had been converted from a substantial collection of un-hedged, sold put options into a hedged package with the risks effectively neutralized. Berndale’s witnesses argued that such a transformation was necessary in order to attract potential buyers. That may be so, but was it authorised to do so at How Trading’s expense?

In late November 2007, Mr Waterhouse had blamed Berndale for allowing him to reach the position where he was unable to meet margin demands. Those complaints resulted in the releases incorporated into the 5 December 2007 agreements. I am not required to decide whether Berndale, as a settlement participant, had any duty to warn Mr Waterhouse of the risks attending his strategy – but it knew of the risks. Mr Ryan described the portfolio as “toxic”. He was familiar with the portfolio from as early as late November 2007.

When Berndale imposed conditions on future trading in the 5 December 2007 agreement it was to confine trading to risk reducing trades. It did not require the portfolio to be hedged or prepared for possible auction. It chose not to interfere with the trading strategy adopted by Mr Waterhouse. When Berndale prevented How Trading from using the margin cap as if an overdraft in late December 2007, it did not then complain that the strategy adopted by Mr Waterhouse was unacceptable. Berndale’s concern was to ensure that Mr Waterhouse use his own funds to close out positions. There was no mention of the need to prepare the portfolio for auction or to hedge it. Had that been part of Berndale’s agenda at the time it would have featured in negotiations.

A reasonably prudent broker may have decided that an auction was the most appropriate means by which it could protect its own position. Even if that was Berndale’s purpose it was required to have regard to the interests of How Trading. It was required to act reasonably in preparing the portfolio for auction and conducting the auction process. In my opinion it was not reasonable for Berndale, at How Trading’s expense, to turn the How Trading portfolio into a new commercial product so as to attract institutional investors, or even to neutralize risk by expensive hedging in the absence of agreement. Further, a reasonably prudent broker would not have delayed until late January or early February to seek approval from the ASX to auction the portfolio. The broker would have expedited the process in its own interests.

Having rejected both interdependent limbs of Berndale’s explanation and justification for its liquidation strategy, the court is left without an explanation advanced by Berndale to explain why it managed the portfolio as it did immediately after taking control. There are possible explanations, but they were not advanced by any party or fully explored in evidence. In the absence of a credible explanation as to why Berndale dealt with the portfolio in the manner in which it did, there remains only suspicion, conjecture and speculation.

The absence of a satisfactory explanation by Berndale, for its management of a portfolio immediately after taking control, does not necessarily translate into a finding that it acted unreasonably or in breach of its duty of good faith. But, when coupled with a contrived or unconvincing explanation and remodelling of the portfolio, the absence of a credible explanation assumed a new importance. On the facts of the present case, Berndale’s duty of good faith required a credible explanation for reshaping the portfolio and to explain why it did not take the most straightforward and simple course of closing out all positions. I am satisfied that Berndale’s restructure of the portfolio, after taking control, was not authorised by the agreement. It was also unreasonable.

Berndale’s right to require How Trading to account to it for liquidation actions is limited to costs and expenses incurred in compliance with its obligations. If Berndale was not authorised to undertake an action, or if it acted unreasonably in the implementation of an action, it is denied the right to require the client to account to it for any loss. Any obligation of How Trading to indemnify Berndale under cl 11 of the Derivatives Client Agreement also presupposes authorised action. There is nothing in the contract that requires payment of whatever sum Berndale may demand.

Notwithstanding their primary evidence that it would have been impossible or at least outrageously expensive or imprudent to close out the positions immediately, Mr Gibson, Mr Ryan and Mr Craft conceded that, had Berndale so wished, it could have closed out the whole of the portfolio on or within a few days of 14 January 2008. The ease with which Mr Craft closed out some positions on and following 14 January 2008 was testimony to the fact that it could be done. The ease with which he closed out Lift Capital positions on 11 April 2008 further confirmed the operation of a market, if confirmation were necessary, priced in the vicinity of the ACH valuations. Notwithstanding the differences between the two portfolios, the strategy adopted by Mr Ryan and Mr Craft in relation to the Lift Capital portfolio further eroded the credibility of their claim that it was impossible to close out the How Trading portfolio at a reasonable cost on and within a few days of 14 January 2008, and thus their justification for the “unwind” strategy.

Mr Best demonstrated by his analysis of the “problematic” positions that the majority of those positions could probably have been closed out at or near the ACH valuation on and within a few days of 14 January 2008. Contrary to the position adopted by Messrs Ryan and Craft, I accept the ACH valuation as a realistic estimate of what might have been achieved in a stable market. While the market for the relevant stocks was volatile, volatility was reflected in the ACH valuations. The market was relatively stable during the week of 14 January 2008. Thereafter, volatility rose dramatically.

I do not accept that the market within which to purchase option positions in order to close out contracts in the How Trading portfolio would have been materially affected by the extent to which the portfolio might have been hedged. The disposal of the portfolio as a whole should not be confused with the purchase of opposite positions to close out contracts. Berndale did not even consider the simplest and most straightforward strategy to deal with the How Trading portfolio, having assumed control on 14 January 2008. They made no real attempt to satisfy themselves of the lack of liquidity or the “outrageous” prices. One might ask why?

Berndale’s witnesses did not rely upon some special knowledge of an imminent catastrophic event such as the publication by Merrill Lynch of an adverse financial report. Instead, they exaggerated a theoretical difficulty in purchasing opposite positions in an active market. A reasonably prudent broker, or a broker acting reasonably, having regard to the interests of its client, would have wanted to know how to dispose of the portfolio at the least cost to itself. Such a broker would have wanted to know what could be achieved in the market to close out the portfolio as soon as practicable. It would have tested the market if its objective was to eliminate its liability as soon as possible.

I am satisfied that, had Berndale investigated the market within which to purchase opposite positions on and within a few days of 14 January 2008, it would have found counterparties. I am also satisfied that the overall cost would not have been significantly higher than the valuations made by the ACH of the whole portfolio on 11 January. Of course there would be exceptions – the analysis undertaken by Mr Best revealed significant percentage variance in some instances. Those examples do not, however, necessarily lead to the conclusion that the overall cost would have exceeded the ACH valuation of the portfolio as a whole. The empirical evidence, in part derived from the Lift Capital experience, would suggest otherwise.

The best evidence of the cost of liquidating the How Trading portfolio is the ACH valuation. I accept that the valuation was not perfect. The evidence of Mr Gibson and Mr Semple was not particularly helpful in that regard. Although Berndale did not test the market to explore the possibility of immediately closing all positions, it did close out some at prices which appear to have been close to ACH valuations or where the variations were not material. The only empirical data available to permit an analysis of actual pricing in the market in the week commencing 14 January 2008 and thereafter is the analysis undertaken by Mr Best.

Finally, there was the concession of Mr Craft – it “would have been the right thing to do”. Mr Craft, in effect, concedes the defendants’ case if, as I have found, there was a market at prices near those assessed by the ACH. Had Berndale done the “right thing” during the week of 14 January 2008, the liability of Berndale and, thus, How Trading would have been confined to approximately the ACH valuation.

Assuming a burden on the defendants to demonstrate a breach by Berndale of its duties under cl 6.4, I am satisfied that Berndale breached it’s duties. The very significant remodeling of the portfolio was not authorised. Berndale’s unexplained restructuring of the portfolio, immediately after taking control, appears aberrant. There is no credible explanation for what was done. The explanation advanced by Messrs Ryan and Craft seemed designed to mask their real purpose.

Berndale failed to investigate the market with the object of investigating the possibility of closing out the positions. A market existed at reasonable prices. In such circumstances, a reasonable broker would have undertaken the investigation and closed out the positions. Mr Craft made that important concession.

CONSEQUENCE

Having concluded that Berndale was not authorised to remodel the portfolio as it did, and breached its obligation to How Trading to act reasonably in the exercise of the default powers under cl 6.4, Berndale is not entitled to bring to account and demand from the defendants losses incurred as a consequence of its breach, whether formulated as a claim for an account or as one for damages. It dealt with the How Trading portfolio at its own risk. It may retain any profits, such as the profit made on short sales, but is liable for losses. Berndale did not set out to establish any value of the How Trading portfolio as at the time it took control. Having rejected the foundation for the extravagant estimates made by Messrs Ryan and Craft, and in the absence of any evidence to explain and justify the valuation made by Mr Gibson, using his bespoke model, I am left with the ACH valuation. I have also found the ACH valuation to be a reasonable estimate of the cost of liquidation. Thus, the amount for which How Trading was liable to Berndale is $5,724,945.99 as at 14 January 2008.

I have found that Berndale did not owe to How Trading a fiduciary obligation as alleged. I have rejected the defendants’ case that Berndale was required to account to it for the actual or notional profits made on the short sales of stock and XJO puts. Accordingly, Berndale’s counterclaim must fail.

AGREEMENT TO INDEMNIFY MRS WATERHOUSE

As a consequence of the findings I have made and the conclusions I have reached, the existence or otherwise of the pleaded obligation of How Trading to indemnify Mrs Waterhouse is of no consequence to the outcome of the proceeding. However, for completeness, I have decided that issue.

How Trading alleged that it became obliged to indemnify Mrs Waterhouse for the loss sustained by her as a consequence of Berndale calling upon the bank guarantee. It contends that its agreement with Mrs Waterhouse is a tacit agreement to be inferred from the parties’ conduct. It relied upon a passage from the judgment of McHugh JA in Integrated Computer Service Pty Ltd v Digital Equipment Corp (Aust) Pty Ltd as follows:[115]

It is often difficult to fit a commercial arrangement into the common lawyers' analysis of a contractual arrangement. Commercial discussions are often too refined to fit easily into the slots of 'offer', 'acceptance', 'consideration' and 'intention to create a legal relationship' which are the benchmarks of the contract of classical theory. In classical theory, the typical contract is a bilateral one and consists of an exchange of promises by means of offer and its acceptance together with an intention to create a binding legal relationship: compare P S Atiyah 'Contracts, Promises and the Law of Obligations', Law Quarterly Review, vol 94, 1978,p 194. A bilateral contract of this type exists independently of end and indeed precedes what the parties do. Consequently, it is an error 'to suppose that merely because something has been done then there is therefore some contract in existence which has thereby been executed': Howard, 'Contract, Reliance and Business Transactions', [1987] Journal of Business Law p 127. Nevertheless, the contract may be inferred from the acts and conduct of parties as well as or in the absence of their words: Empirnall Holdings Pty Ltd v Machon Paull Partners Pty Ltd 14 NSWLR 523. The question in this class of case is whether the conduct of the parties viewed in the light of the surrounding circumstances shows a tacit understanding or agreement. The conduct of the parties, however, must be capable of proving all the essential elements of an express contract: cf Baltimore and Ohio RR Co v US 592 (1923); Fincke v US F 2d 289 (1982). Care must also be taken not to infer interior promises from conduct which represents no more than an adjustment of their relationship in the light of changing circumstances.
Research in the United States and Great Britain suggests that probably the majority of people in ongoing business relationships regulate their relationships in accordance with what they consider is fair and reasonable or commercially necessary at particular points of time rather than by reference to a priori rights and duties arising under a contract: Beale and Dugdale, 'Contracts Between Businessmen', British Journal of Law and Society, [1975] p 45; Lewis, 'Contracts Between Businessman', Journal of Law and Society, [1982] p 153. This is the case even where their relationship is governed by a written contract. There is no reason to suppose that the position is any different in Australia. For this reason 'action and conduct before the inception of a controversy is of much greater weight than what they said or did after a dispute arose': Fincke v US at 295.
Moreover, in an ongoing relationship, it is not always easy to point to the precise moment when the legal criteria of a contract have been fulfilled. Agreements concerning terms and conditions which might be too uncertain or too illusory to enforce a particular time in the relationship made by reason of the parties' subsequent conduct become sufficiently specific to give rise to legal rights and duties. In a dynamic commercial relationship new terms will be added or will supersede older terms. It is necessary therefore to look at the whole relationship and not only at what was said and done when the relationship was first formed.

[115](1988) 5 BPR [97326].

How Trading was dependent upon financial accommodation provided by Mrs Waterhouse. That did not change on 5 December 2007 when the defendants agreed to procure a Westpac Bank guarantee supported by Mrs Waterhouse. Mrs Waterhouse had previously required, and was given, a charge over the assets of How Trading for prior financial accommodation.

Berndale submitted that neither Mrs Waterhouse nor Mr Waterhouse gave evidence about any explicit communication concerning the alleged indemnity agreement. There was some suggestion that there might exist a written agreement although that was never produced.

The relationship between Mr and Mrs Waterhouse in connection with financial accommodation given to How Trading cannot be characterised as an unenforceable domestic arrangement. Mrs Waterhouse had independent advisers. Mr Tighe was one of them. It is perhaps curious that the position of Mrs Waterhouse was not better protected by a written agreement under which How Trading, and perhaps Mr Waterhouse, agreed to indemnify her in relation to any loss she may sustain as a consequence of How Trading’s business. Nevertheless, insofar as it is relevant to the outcome of this proceeding, I find that the circumstances surrounding the agreement to give the bank guarantee and the procuring and delivery of that guarantee, for which Mrs Waterhouse gained no apparent benefit, disclose a tacit or implied agreement by How Trading, through Mr Waterhouse, that she would be made whole should the guarantee be called upon.

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